RALEIGH – North Carolina requires local governments to maintain reserves of at least 8 percent of their annual budgets, just in case of natural or fiscal disaster. But North Carolina’s state government has never that much money socked away in its own rainy-day fund or other reserves.
At times of fiscal distress, such as the present moment, some legislators and outside analysts will argue that North Carolina should adopt new policies to strengthen our rainy-day fund, such as requiring a set annual contribution or setting an 8 percent floor on the fund balance. I’m not against such measures, but I’d urge lawmakers not to invest too much confidence in them.
North Carolina’s failure to build adequate rainy-day reserves is a problem. Remedying it would help the next time the business cycle slams government revenues and opens up a budget deficit. But inadequate savings is really a symptom of a larger problem – excessive revenue and spending growth during boom years.
Our state is more reliant than most on a multi-rate income tax to finance state government. When the economy is healthy, such a system throws off gobs of new revenue because households move into higher tax brackets and thus pay higher shares of their growing incomes to the state treasury. The flip side, as we are experiencing right now, is that states dependent on multi-rate income taxes have bigger revenue crashes during recessions as households fall out of higher tax brackets.
During the good times, the government can do one of three things with extra revenue dollars: spend them, save them, or give them back to taxpayers to spend or save privately.
Historically, most of these dollars have been spent on more and bigger government, not saved or returned. No surprise here. The incentives point strongly in the direction of public expenditure. When strong economies juice revenue collections, spending allows public officials to win the favor of powerful lobbies (teacher unions, Medicaid vendors, the construction industry, etc.) and feel good about “doing something” to address social problems without having to anger taxpayers by raising their rates.
The general public may have a strong interest in seeing their government either save for a rainy day or reduce tax rates, but they are not organized and represented in Raleigh at the same level as the spending lobbies. Only at times like these, when big deficits seem likely to result in tax hikes, is there much of a political payoff from spending restraint. So now is, indeed, the time to push for fiscal mechanisms to put a brake on the next boom-and-bust spending cycle in Raleigh.
Strengthening the state’s rainy-day fund is worth doing, but insufficient. A new paper from Florida Gulf Coast University’s Dean Stansel and the University of South Alabama’s David Mitchell delves deeply into the academic literature on state reverse requirements and spending habits. Stansel and Mitchell set up a new model to test the effectiveness of rainy-day funds in heading off what they called “fiscal stress” – measured as a combination of the size of tax increases and below-trend spending cuts during recessions.
The researchers found that the mere existence of a rainy-day fund had no clear relationship to the likelihood of fiscal stress. They found some evidence that specific rainy-day policies – such as higher deposit requirements or withdrawal limitations – were associated with less fiscal stress, but even these findings were not statistically significant.
What is needed is a broader control on the boom-and-bust cycle, in the form of a strict annual cap on state spending growth. Call it a Taxpayer Protection Act or a Taxpayer Bill of Rights, but such a spending cap is the only way to maintain fiscal discipline during periods of rapid economic growth. Allow expenditures to rise enough to keep up with monetary inflation and population growth. Require that unspent funds be accumulated in North Carolina’s rainy-day fund until it reaches a set percentage of the General Fund budget – 8 percent sounds like a reasonable minimum – and return the remaining dollars to households via tax relief.
The Stansel/Mitchell study shows why spending caps are the key. It showed that the pace of spending growth before recessions was, indeed, significantly associated with the size of the ensuing fiscal stress. The average state showed a 3.7 percent increase in fiscal stress for every standard-deviation increase in the average prior increase in General Fund budgets.
In other words, North Carolina should certainly save more for our fiscal rainy days – but it’s more important that we engage in some fiscal weather control in the first place.
Hood is president of the John Locke Foundation